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AUSTRALIA'S FOSTER'S GROUP has learned the hard way what drinkers have long known: mixing beer and wine can make you sick.

Nearly a decade ago, executives at Foster's, which commands 52% of the local beer market, feared that there wasn't much room to grow and that extending their brewing expertise throughout Asia would be a tough task. One brief foray into China had ended badly. Seeing Australians growing wealthier, management focused on wine and went on an 8-billion-Australian-dollar (US$5 billion) spending binge at home and in California.

So Foster's (FGL.Australia) product roster now includes "Joe six-pack's" favorites, Foster's Lager and Victoria Bitter; mixers like Italy's Cinzano; and market-spanning lines of wine like Rosemount, Lindemans and Napa Valley, Calif.'s Beringer -- all the way up to $5,000-a-bottle-plus vintners like Grange Hermitage, which produces a vintage Shiraz that's highly prized by collectors worldwide.

New CEO Johnston: "We have to say that our performance in the last 12 months has not been up to what we would expect ourselves."
Kristian Gehradte for Barron's

THE PROBLEM IS that Foster's splash into wine hasn't produced the froth that its beer business, started by two American emigrants 122 years ago, continues to. In its most recent fiscal year, to June 30, wine made up 48% of its $A4.4 billion revenues, but just 33% of its roughly $A1.2 billion of operating profit. Foster's also had to write down $A730 million of its expensively acquired vineyards. Overall, revenue fell 4%, mostly due to currency adjustments, and net profit dropped 88%, owing to the write-downs.

The languishing stock (it's traded mostly in the $A5-$A5.50 range since its last big wine acquisition in 2005) jumped from $A4.40 to near $A6 in recent weeks before falling back to $A5.05 last week. Some analysts see 20% or more upside if bidding interest does emerge or it undertakes a meaningful reorganization.

"Our portfolio is in very good health, but we have to say that our performance in the last 12 months has not been up to what we would expect ourselves," Chief Executive Officer Ian Johnston tells Barron's.

Johnston took the top post on Sept. 25 from the ousted architect of Foster's push into wine, Trevor O'Hoy, and is still reviewing the company's options. O'Hoy, who ran up Foster's debt, wanted to take its famous slogan of "Australian for beer, mate" and make it "Australian for wine," too.

FOSTER'S SHARE PERFORMANCE contrasts with the startling gains in Australia's commodities-driven market, until the recent bear market started rippling Down Under. Australia's benchmark All Ordinaries index has nearly tripled since Foster's began its wine splurge in the late 1990's, while Foster's shares are only up by about 40% in that time, barely in line with economic growth.

Foster's staked almost $A4 billion to buy premium Australian wine-producer Southcorp, whose brands -- such as Penfolds and Lindemans -- help make it the world's No. 2 wine bottler, after Constellation Brands of Fairport, N.Y. But the shares have barely budged since, except for a spike to $A7 a year ago, as the broader market doubled.

The chief headache is sales; Foster's uses the same sales force that was raised on mass-marketing beer and cheap spirits to sell in Australia's big so-called beer barns to market its pricey wines to chic restaurants and liquor stores catering to connoisseurs. If Foster's transformation into a global wine heavyweight proved anything, it was that it excelled at brewing and selling beer.

In "hindsight, some of our marketing assumptions were flawed," says Johnston, 61, a former senior exec at Unilever and Cadbury Schweppes. "We are now making sure we service our customers directly rather than take a one-size-fits-all approach."

Analysts were skeptical about the Southcorp purchase from the start. Citigroup said "the price looked rich," and Merrill Lynch went so far as to say that O'Hoy was making a "mistake." But O'Hoy was unperturbed. In an interview at the time, he said that "beer is the engine room of our business plan, wine is where we see a lot of growth." Southcorp, he said, "was a perfect strategic fit." Foster's wine assets had previously tilted downmarket.

"Southcorp was a good fit at the time, but it wasn't managed into being one," says David Cooke, Sydney-based beverage analyst at ABN-Amro Australia. He adds that while "Foster's bought premium brands with Southcorp...they needed to be finessed individually, in a much different manner."

Currency has bedevilled Foster's, too. It reports in Australian dollars. From June 2005, when the Southcorp deal closed, to June this year, the Aussie dollar rose from 74 cents to the U.S. dollar to peak at 98 cents, devaluing its U.S. holdings and making exports from Australia tougher. Now it's down to 66 cents to the U.S. dollar, which should help Johnston's numbers right away.

Matt Williams, senior portfolio manager at Sydney's Perpetual Investment, which holds Foster's stock, says its "very poor acquisition strategy" has soured investors. "They paid too much and they bought at the wrong time in the cycle," he says.

Some analysts believe the company should empty its wine glass and focus on its strength -- brewing beer.
Barron's Graphics

UNHAPPY SHAREHOLDERS, of course, can open the door to an acquirer. In July, America's biggest brewer, Anheuser-Busch, took a $52 billion offer from InBev (for more on that deal, see Preview), and analysts set their sights on new targets. Foster's market value of $A9.7 billion makes it a big deal by local consumer-business standards, but not out of reach for the global majors like Diageo or South Africa's SAB Miller, Pernod-Ricard and, indeed, InBev.

UBS recently valued Foster's beer assets alone at around $A11 billion, close to its current market capitalization, which would hand a Foster's buyer a top-shelf wine portfolio for virtually nothing.

"I wouldn't even like to guess whether anybody is looking at us," Johnston says. "Our only focus has to be on making this a world-class beverage business that our shareholders want to be part of and that they can rely on for steady growing returns."

Still, Foster's just appointed Goldman Sachs to advise on a possible bid defense.

Upon becoming CEO, Johnston immediately began reviewing the wine operation. To investors, that means he's assessing what vineyards to sell. "To be honest, we haven't realized the volume growth we said we would," says Johnston. "I'm here to recover from what has been a disappointing year." But he denies that he's prepping Foster's for a sale. "I don't think the board is trying to make us a takeover target. The best way to keep your shareholders committed to the company is based on performance."

Cooke says investors shouldn't assume that Foster's is an acquisition magnet for a big beverage player: "Private equity could also be a factor here." But even that has complications, because marketing and distribution are closely aligned. And private-equity firms are financially constrained now.

"Separating the wine, and then the beer and the spirits as a group?" Cooke asks. "I'm not so sure whether a vanilla separation of the beer and wine assets would add significant value. But cherry-picking some of the premium-wine brands could add value, particularly on the wine side."

Meanwhile, the beer business is doing well, Cooke says. "It is also the business likely to be most attractive to others." Big brewers tend to take single-digit share from each other through inventive marketing and product diversification, though analysts expect beer volumes to rise at the expense of wine, as recession worries sink in, and some consumers forsake what they regard as a luxury. Foster's has an effective duopoly in Australian beer with Lion Nathan, controlled by Japan's Kirin.

"If anything, the beer side overearns; it generates very high returns," Williams says, adding it would "eminently sellable." But the divestment -- even the fire sale -- of any wine assets may be tough because there's a glut of vintners on the Australian market, as Constellation moves to sell production facilities and as many as 20 brands. Williams thinks a split of the company could be in the offing, separating the beer and spirits division from a stand-alone wine division. He foresees an $A6-plus share price, "but only if the new management make the right calls."

The Bottom Line

Foster's shares could jump 20% if an acquirer or reorganization materializes. The brewer's market value now about equals that of its beer unit. You get the wine portfolio for free.

Perhaps Foster's best bet is to go back to basics. Selling the bulk of the Southcorp labels could yield $A4 billion to A $5 billion, canceling debt and letting Foster's belly up to international rivals in the sector in which it does best -- beer.

"They have finally faced up to the mistakes of the past," Williams says. "So I reckon it's watch this space and see what happens." No matter what, Foster's remains Australian for beer.